Stock Brokerage companies are companies which, among other things, hold customer brokerage accounts. Customers can instruct the brokerage company to buy and sell securities held in their brokerage accounts. In some cases the customers will also choose to take a loan from the brokerage company, where the loan can be used to purchase securities held in the customer's brokerage account. The loan is secured by the securities held in the customers brokerage account. These loans which are secured by the securities held in the customers brokerage account are referred to as “margin loans”.
The margin loan is extended to the customer pursuant to a margin loan agreement which provides among other things that the customer will pay a specified rate of interest on the margin loan. Aspects of the administration of the securities and lending activity for margin loans are governed by Fed Regulation T and NYSE rule 431. Among other things these regulations require that customers equity in the brokerage account which is the subject of the margin loan must exceed the value of the margin by specified amount. Thus, the stock brokerage company should be protected from the prospect of the falling stock prices causing the customer to be unable to repay an outstanding margin loan. In situations where the value of securities in the customer's brokerage account drops below a specified amount relative to an outstanding margin loan, the brokerage company will issue a margin call to the customer. In response to a margin call the customer must either increase the equity of the brokerage account by either depositing additional cash or securities into the brokerage account which is subject the margin call, or the customer can sell securities held in the brokerage account, and proceeds from the sale of the securities can be used to pay down the amount of the margin loan. In some cases where the customer does not respond in a timely manner to a margin call, the brokerage company may take the initiative and sell certain securities in the brokerage account to reduce the amount of the outstanding margin loan.
Brokerage companies enjoy several benefits from extending margin loans to customers. For example, brokerage companies can earn substantial income from the receivables (i.e., the interest payments on the margin loans). Brokerage companies can also benefit from the additional transactions and customer activity that results from a customer's ability to obtain margin loans. Extending margin loans can also have some drawbacks for brokerage companies. One disadvantage of margin loans is that the lending of cash to customers reduces the cash reserves for the brokerage company. Further, in an extremely volatile market the brokerage company is also subjected to the risk that rapidly falling stock prices could make it difficult for the brokerage company to recover the full amount of a margin loan for an account where a customer is not able it meet a margin call. One widely used method for addressing situations where the owner of an asset would like to create funding and reduce their risk with respect to the asset is to securitize the asset. Thus, given the historical use of securitizing assets, one obvious solution for a brokerage company would be to use the structure shown in FIG. 1 to securitize margin loans.
The diagram in FIG. 1 shows a securitization process for margin loans, such a securitization process is a typical approach used in the past to securitize as an asset. Provided herein is a discussion of the diagram describing margin loan securitization relative to the complex regulatory and business environment which relates to the brokerage industry in general and to margin loans in particular. As shown in FIG. 1 a customer 102 receives a margin loan 104 from brokerage company (shown as Broker/Dealer). In return for the margin loan the customer transfers 106 a security interest in securities held in the customer's brokerage account and assumes an obligation to pay interest, or receivables, on the margin loan.
As shown in FIG. 1, margin loans originate at the brokerage company, which is a registered broker-dealer and member of the National Association of Securities Dealers. After making the margin loan, the brokerage company can sell the margin loans and assign the security interest in the securities collateralizing the margin loans, to a special purpose vehicle (“SPV”) on settlement date pursuant to a “Receivables Purchase Agreement”. As shown in FIG. 1, the selling of the receivables (the margin loans) and the assigning of the security interest are at 108, and the payment 110 from the SPV to the brokerage company are at 110.
The SPV will be a wholly owned subsidiary of the brokerage company. The SPV can be capitalized by the brokerage company, or depending on the structure of various entities related to the brokerage company, might also be capitalized by another entity which owns or is affiliated with the brokerage company.
Broker-Dealer Registration: Exchange Act section 3(a)(4) defines the term “broker” to include any person engaged in the business of effecting transactions for the account of others. Exchange Act section 3(a)(5) defines “dealer” to include any person engaged in the business of buying and selling securities for his own account, through a broker or otherwise. Neither the SPV nor the Trust, as described below, triggers the Exchange Act's broker-dealer registration requirements since these entities would not: (i) receive compensation based upon the value or volume of transactions effected, (ii) communicate or deal with customers except through a registered broker-dealer, (iii) be involved in the negotiation of transactions, (iv) clear or settle transactions, (v) handle customer funds or securities or (vi) solicit business in securities.
The SPV's purchase of the customer receivables 108 and 110 will be funded in part by a liquidity facility provided by an entity 114 which owns or is affiliated with the brokerage company. In exchange for this funding 112, the SPV will provide a promissory note 116 to the entity 114.
The SPV transfers 118 the margin loans and assigns the security interest in the securities collateralizing the margin loans, to a business trust (the “Trust”) 120 pursuant to a pooling and servicing agreement (“Pooling and Servicing Agreement”) between the Trust, the SPV and brokerage company. The payment 122 to the SPV for the transfer of the customer receivables to the Trust is financed by the Trust's issuance of business trust certificates 124. These business trust certificates 124 will be issued to third parties (“Series Certificates”). In addition, the SPV will likely retain an interest in the Trust and its interest will be reflected through the issuance of a business trust certificate 124 (“Transferor Certificate”). Both types of business trust certificates evidence an undivided ownership interest in the assets of the Trust (i.e., cash and customer receivables). The transactions between all entities and the issuance of funding occur simultaneously (i.e., the same day).
Funding for the purchase of the customer receivables from the Trust will be accomplished by issuing commercial paper (CP) and/or notes to the capital markets. CP can be issued in exchange for payment 129 from an existing commercial paper conduit. The conduit will purchase 116 a Series Certificate 124 from the Trust and in turn issue CP 128 secured by the Series Certificate. Alternatively or in addition, notes 130 can be issued to term capital market investors 132 in return for payment 133 through an Owner Trust 134. The Owner Trust will pay 136 for a Series Certificate 124 and issue notes 130 secured by the Series Certificate 124 to fund its purchase. The Series Certificates will receive a rating of at least investment grade or the equivalent by each one or more nationally recognized rating agencies. The ratings of the Series Certificates would not be dependent upon the ratings assigned to any obligations of the broker-dealer. The funding strategy can depend on the amount and expected duration of margin loans sold. The transaction size will depend on brokerage company's liquidity needs at the time of issuance.
This two-step sale structure will isolate the assets of the brokerage company through a true sale and remove the assets related to the margin loan from brokerage company's consolidated GAAP financial statements. The Trust will not have recourse to brokerage company for margin loan losses. The sale of the Receivables by the brokerage company to the SPV would be treated as a sale for commercial law, bankruptcy, and accounting purposes. The structure does not require that future receivables generated by a customer account whose existing receivables have been sold to the Trust be automatically sold to the Trust.
The SPV and the Trust will be deemed Regulation T lenders under the Federal Reserve regulations. This designation occurs because both the SPV and the Trust will, respectively, be deemed to be directly and indirectly controlled by the brokerage company. Customers whose debits have been sold will remain subject to Regulation T.
Pursuant to the Pooling and Servicing Agreement, the broker-dealer would agree to act as servicer of the Receivables (“Servicer”). The Receivables sold to the Trust would be serviced in accordance with customary commercial servicing standards by the broker-dealer. As the Servicer, the broker-dealer would hold all of the documents relating to the Receivables. The transaction documents would require that all payments on the Receivables be remitted by the obligors directly to a segregated trust account. The trust would pay a periodic fee to the broker-dealer for its services as the Servicer.
As shown in FIG. 1 the brokerage company will assign to the SPV the 108 security interest granted by the customer to brokerage company, and the SPV will transfer the 118 assigned security interest to the Trust. The brokerage company is not granting to either the SPV or the Trust a lien on or security interest in the customer securities. Rather, the brokerage company is transferring the assigned security interest granted to it by the customer. This is a securitization process, and not a traditional rehypothecation bank loan transaction whereby the brokerage company would grant a lien on customer securities to the lendor which would serve as collateral for the loan to the brokerage company.
In the securitization structure a lien granted by a customer on its securities to the brokerage company is transferred by the brokerage company to a third party, and will continue to secure credit extended to the customer and does not serve to secure credit extended to the brokerage company.
In operation of the above described securitization process it is helpful to consider aspects of agreements and regulatory requirements that come into play. Some of these agreements and regulatory issues are discussed below.
Intercreditor Agreement
Although the security interest securing the margin loan has been assigned to the SPV and the Trust, the customer agreement is still effective to create a separate security interest to secure all obligations owed to the brokerage company that have not been sold to the SPV. Because of this possibility of multiple security interests, the brokerage company, the SPV, and the Trust would enter into an intercreditor agreement that provides that the various security interests granted by the customer have the same priority and share in the collateral on a pari passu basis (based on the value of the obligation owed to each entity).
Custody of Customer Securities.
SEC Rule 15c3-3 (i) requires broker-dealers to obtain promptly and thereafter maintain the physical possession or control of all fully-paid and excess-margin securities and (ii) establishes customer-reserve requirements based on a formula contained in rule 15c3-3. To the extent that the brokerage company sells, and therefore no longer holds, a margin loan in a customer account, the brokerage company will continue to hold the securities on behalf of the customer. Neither the SPV nor the Trust will ever hold customer funds or securities. The brokerage company is only selling an asset (its right to re-payment of the margin loan it extended to its customer). The brokerage company is not transferring or selling the customer securities.
The securities in accounts with sold margin loans will be deemed fully-paid securities, as that term is used in SEC Rule 15c3-3. Accordingly, the brokerage company would be required to reduce the customer's securities to possession or control. The brokerage company's assignment to the SPV and Trust of the security interest granted by the customer will not prevent the brokerage from reducing the customer securities to physical possession and control. All customer securities securing a sold receivable will be held in a good control location and the securities will be under the control of the brokerage company. Customer securities in accounts with sold margin loans will not be rehypothecated.
Customer Servicing
As discussed above, the brokerage company will sell the customer receivables to a SPV which will then sell to the Trust. The brokerage company is not selling or transferring the customer account and is not assigning any obligation under the customer-account agreement between the customer and the brokerage company. The brokerage company remains the account owner. The brokerage company will continue to be responsible for custody of customer funds and securities, handling and executing customer orders, clearing and settling customer transactions, providing confirmations and statements and complying with all customer-protection laws, regulations and rules. All obligations remain with the brokerage company. The Trust will establish a servicing agreement with the brokerage company for collection activities. The brokerage company, as agent for the Trust, will collect and remit cash that flows into the customer account to the Trust until the customer receivable is cleared. For example, if any of the securities in the account are liquidated or transferred, the brokerage company will be required to remit the proceeds deposited into the customer account to the SPV or the Trust.
Margin Requirements, Policies and Procedures
Pursuant to the Pooling and Servicing Agreement, the brokerage company will be primarily responsible for ensuring compliance with Fed Regulation T and NYSE Rule 431 (collectively, “Margin Regulations”). The brokerage company will maintain all books and records necessary to demonstrate compliance. Any calculation of initial or maintenance margin will be performed on a consolidated-loan basis. The brokerage company will further be required to conform to industry best practices with respect to the establishment of margin policies and procedures. Consistent with this standard, the brokerage company will continue to handle all customer margin accounts in accordance with the margin policies and procedures applicable to all customer margin accounts, without regard to the owner of the right to repayment of the margin loan. The Trust will have no authority or ability to establish specific margin policies, including without limitation: (i) requiring maintenance margin in excess of the brokerage company's maintenance-margin requirements, either on an account-by-account or security-by-security basis, (ii) demanding additional collateral to secure existing margin loans, (iii) determining interest rates or other finance charges applicable to customer margin-loans, (iv) determining the method of computing interest or outstanding debit balances, (v) denying extensions of time to meet margin requirements, or (vi) requiring sufficient collateral value be on deposit with the brokerage company on trade date. The Trust will have the right to issue entitlement orders to the brokerage company requiring the brokerage company to liquidate customer securities securing Receivables sold to the Trust, just as the brokerage company would have the such right.
NYSE Rule 328
New York Stock Exchange, Inc. (the “Exchange” or “NYSE”) rule 328(a), provides that “[n]o member organization shall consummate . . . a sale or factoring arrangement with respect to any customers' debit balances without the prior written authorization of the Exchange.” Thus, the brokerage company is required to request approval from the Exchange to sell customers' debit balances as part of its securitization program.
Series Certificates
Under the above structure, the Trust would issue Series Certificates either to a Note Master Trust or to institutional investors who are Qualified Institutional Buyers, as such term is defined in the Securities Act of 1933, as amended (“Securities Act”). The Series Certificate would represent an undivided interest in the Trust. The purchase of a Series Certificate, which is an equity security, whether in a private placement or public offering is not deemed to be an extension of credit for purposes of Regulation T.
Commission and SRO Oversight
NYSE rule 321.20 provides that a member's “subsidiary shall keep books and records separate and distinct from those of the member . . . and such books and records shall, upon request, be made available by the member or member organization for inspection by the Exchange.” The SEC retains authority to inspect the books and records of these subsidiaries, pursuant to Exchange Act section 17(h)(1), which states that the Commission may require broker-dealers to make reports concerning the financial and securities activities of associated persons whose business activities are reasonably likely to have a material impact on the financial or operational condition of such broker-dealer. Exchange Act section 3(a)(21) defines associated person, in relevant part, as any person controlled by a broker-dealer. Both the SPV and the Trust will be deemed to be associated persons of brokerage company and their books and records available for inspection by the Commission or the NYSE.
SIPC/Bankruptcy
Customer protection from SIPC is not impacted by this transaction. The brokerage company owes the securities to its customers, just as it does when the brokerage company lends customer securities (i.e., marginable securities) or when the customer obtains credit from a third party and posts its securities as collateral. SIPC's coverage is not in any way affected simply because a third party has a security interest in those securities.
Much of the above discussion is focused on obvious securitization approaches for securitizing margin loans, and the legal and business implications that flow from such a process, but what is not obvious is how one would design a system and method to facilitate the securitization of margin loan, and the subsequent tracking and administration of such loans.